Preston Pysh  1:21  

We all sent out our picks for this quarter’s Mastermind discussion. Do we have any volunteers to go first? I know we always debate over who’s going to go first, but is anyone excited to talk about their pick?

Tobias Carlisle  1:32  

I’m definitely not excited about mine but I’ll take a swing at it because you guys are warming up and can get nastier as we go along. 

While everybody’s sort of still a little bit nervous about the start of the call, let me do my mine. Mine is HPQ, HP, the printer business of the old combined entity before it’s spun out. So I bought this post spin in 2016, something like that. It was trading for about $11 and now it’s $22. It’s up a lot. I haven’t seen it for years and it’s sort of floated back into my screen. 

It’s interesting. $34 billion market cap price earnings, currently about 6.8 and which is cheap… HPQ, it’s been higher, it’s been lower. The reason is that it’s a little bit cheaper, there’s some compression in their EPS, so it’s likely that I had $3.25. Next year, it’s going to be lower than that. 

Throwing up plenty of free cash flow and paying a dividend buying back stock is one of the reasons that I like this business. I think that they have a good attitude towards shareholders. So they do buy back stock, they do pay dividends. I think that you’re going to get a lot of return out of the stock from shareholder friendly maneuvers like that. 

12% of the return over the last few years has come from those returns of capital, whether it be dividend or share buybacks. I think that will continue on because it seems to be throwing off cash and it seems to be doing pretty well. 

Price earnings are at 6, I’d say is below the five year average and at a pretty substantial discount to every other stock in the index. It’s certainly below where it was last year and the year before. So it’s had some compression in the stock price as well.

Many of their concerns about it are pretty simple to say. One of them is that it’s carrying more debt than I would ordinarily pitch to you guys. So the balance sheet is a little bit weaker than I typically like to see. There’s also just eyeballing on that balance sheet. The book value doesn’t sort of tell you quite how bad it is, because some of that book value is goodwill. And so, it looks like it’s about a $600 million negative book value, sort of $6.6 billion of that includes some… I mean, the $6.6 billion that includes goodwill and other things that I wouldn’t really count. 

On the positive side, I do think that it’s pretty steady business. The risks are just general sort of macro risks that something really nasty happens in the economy. But HPQ has been around for a long time. They’re making printers, hardware stuff that nobody really wants to be in anymore, but I think that this is kind of a model for a business that will just keep on muddling through and you’ll get… 

I don’t have great hopes for the returns but I think that you can sort of make 8% to 10% over the next five years because I think of the valuation. Stocks are currently trading at $22. I see valuations around $35, even assuming a little bit of diminution in the earnings going backwards a little bit here. I just think it’s too cheap where it is. 

I think that’s about a 50% upside model for a business, whether they’re sort of looking after the shareholders with the proviso that the balance sheets are a little bit weak. If we really see some nasty macro, then I have to revisit it. That’s my pick.

Preston Pysh  4:33  

My only comment, Toby, is really kind of your last piece of how you see the macro piece kind of playing into this because if we are, in fact, hitting a top right now and preparing for a recessionary period, then I will obviously talk a lot about that during my pick. However, I’m kind of curious how this type of company performs during those periods of time?

Tobias Carlisle  4:56  

It’s hard to say because it’s always been part of the way it was spun out. It hasn’t traded by itself. Naturally people put off buying these sorts of things. You don’t need a new printer, you can push that back so they are a little bit cyclical. 

I don’t invest so much looking at that macro picture because I just tend to sort of hunt around for what I think is the cheapest at any given time. I also run my portfolio long short, so I have some ugly stuff. I could have pitched just some shorts. I don’t want to pitch a short. I might change my mind on it in three months and then have somebody tell me in two years time. I’m still in that short, that would be a bad thing. 

Preston Pysh  5:34  

Speaking of which, and we’re all laughing because my pick later is a short. Go ahead, Hari.

Hari Ramachandra  5:41  

I think this is an interesting pick. I wanted to understand how you see it? Is it more like a cigar butt? Like you want to have like *inaudible*? Or do you think it’s a long term bet?

Tobias Carlisle  5:52  

I don’t think it’s a cigar butt. It’s a business that’s going to be around for a long time and I think that it’s going to sort of muddle through and maybe there’s a little bit of growth in it over the longer term, not in the short term. It’s probably going to go backwards a little bit. So I don’t think it’s one path. I think there’s more to it than that, but it’s certainly not that sort of Buffett compounder.

It’s the kind of business that I like where the business short term looks really ugly, but the underlying business is pretty good. It’s pretty cheap where it is so I don’t have high hopes. I don’t know where this will be in 10 years time, but in two, three years time or five years time, I think this is still a good business.

Stig Brodersen  6:33  

I don’t know if it was the printer business you’re also getting at before, Hari. I mean, it looks like what we will see in terms of printers is that we’ll have fewer printers, perhaps not as expensive printers. It won’t have as vital importance for most businesses. That is one of the concerns I would have. 

Then if you look more at what they’re saying, we have this new generation of 3D printers. They’re going to be leaders in that. I guess my concern for a pick like this is I can’t necessarily see how the moat they used to have and perhaps have around printers can be transferred to the new era of 3D printers?

Tobias Carlisle  7:07  

Yeah, I don’t know that they have much of a moat in the existing printer business but I don’t think that 3D printers are such a game changing technology. From their perspective, it doesn’t really change what they do that much. I don’t know, I could be wrong. Maybe 3D printing takes over the world. 

I still think that a lot of the reason that people buy a printer is you need at some stage to get what is on your computer into printed form that you sign and give to somebody else. That’s definitely diminishing… You need less and less. We’re not a paperless office yet, but we’re sort of trending in that direction. I don’t think that 3D printers are going to take over from that. 

However, I think that everybody always assumes that these things happen very quickly. I mean, we’ve been hearing about the paperless office for a very long time. I think that it takes a long, long time and in that there are going to be some changes in the business.

Hari Ramachandra  7:50  

Yeah, I think that’s a good point that you brought up that they don’t really have *inaudible*. It’s more like a commodity business but at the same time to have a lot of legacy, in terms of their printer division distribution channel and all that stuff. 

For me, the only concern I have is the way I’m looking at it is like when we were talking about when Buffett invested in IBM, we were also thinking of the same lines of short term problems where they might work out and then they’re buying back their shares. So in the long term, it might be a good investment. My only concern would be that this is like a value trap.

Preston Pysh  8:28  

I kind of see it the same way as Hari. It kind of feels like a value trap. I think it’s important for people that are listening to this conversation that when you hear Toby talk about how he originally took his position in this, it was back when there were gains to be had and a lot of those gains have actually occurred and matured. I’m not one to really talk too much about the momentum piece in a bit. 

It appears like a lot of the price action is starting to stall out on this. I don’t know if that’s an indicator of what’s to come or not, but it’s not something that gets you really excited. 

I don’t know, Toby. I think it’s important for people to understand that you got in this at a different period of time and you didn’t necessarily buy it last week.

Tobias Carlisle  9:09  

To be fair, I bought it in 2016. Then I sold out of it about a year later. I haven’t looked at it since that period of time, but it came back into my screen more recently with this volatility. So it’s trading at $22.1 right now. It’s off pretty substantially from. I think it topped out at $26.42. So it’s down about 20%, along with a lot of other businesses of this type. 

When I first bought it, it was post spin, and everybody who’s a value investor loves those post spin things because nobody can sort of analyze them properly. You just know that if you buy it, management’s going to figure it out, it’s going to work out. This is not that situation. It’s a little bit more mature, but I do think that this is still… 

It’s a tough market out there. There’s a lot of overvalued companies, there’s FAANG and a lot of those other businesses that are extremely overvalued. So this is not an overvalued business, but you don’t get undervalued businesses without a little bit of hair on them. There is some hair on this business and then there’s sort of the metaphysical questions about how much people print in the future.

Printing doesn’t make up a huge portion of their revenues. It’s a business that it’s easy to find all the things that are wrong with it, but you’ve got to look at the fact that it is sort of undervalued where it is. I think it’s not one that you compound away for five years, but I think it’s one that is a pretty steady return over five years.

Stig Brodersen  10:20  

Another thing I would like to add. I’m really sorry that you actually went first, Toby, and we had all our frustration. 

I think it’s a very interesting pick. I don’t think there’s so much wrong with it as such. This is not your… We talked about Google. I know that they had a big *inaudible*, but we actually talked about that last time, but it’s not Google that compounds with 20% a year with huge network effects. That’s not what we are talking about. 

That’s also why you see a company like HP that’s trading at seven times earnings. Some investors might be out there thinking, “Well, I’m just going to wait until now it trades at 14 times earnings like a great company.” It’s probably not going to do that. It’s probably going to stay around that, call it 6,8, 10 whatever. I don’t see it going higher than that. 

I think you’re right, Toby, that it will come through how shareholders have been rewarded and it will be like a slow and steady race. Perhaps, it is going to be. Slow and steady is going to win the race, but it’s not going to outpace anything in the short run. 

Hari, I see you have a point.

Hari Ramachandra  11:20  

I want also to *inaudible* on what Toby said, like the paperless office. All this kind of trends I’ve seen, even in the heart of the Silicon Valley, I still see and I still see myself, I want to read and sign documents and I still take a printout

Preston Pysh  11:41  

You don’t put it on your iPad? I agree with Hari. I don’t buy into this whole 3D printing thing either. I mean, the 3D printing I remember doing that when I was a college student a long, long time ago. It’s just not something that I think is going to be this revolutionary thing that’s just going to burst out of nowhere.

Tobias Carlisle  11:58  

I think it’s going to be cool, but I don’t think we’ve kind of figured out what it’s for yet. Somebody will figure that out, but it’s not obvious yet.

Stig Brodersen  12:06  

All right, anything else guys? Should we go to the next pick?

Hari Ramachandra  12:09  

I can go next. Toby has broken the ice now. I’m feeling a little bit more brave. So my pick for today is HDFC Bank, which is a private bank in India. 

One of the motivations for me was recently, Buffett took a large stake in multiple banks. That was interesting to see. I think almost $14 billion, if I’m not mistaken. 

To give you a bit of background about banking in India, there used to be private banks at one point of time, but in the 1970s, they just nationalized all the banks. They are called public sector banks basically.

In 1994, as part of the liberalisation efforts, they opened up banking; there were a few banks that were founded in 1994. HDFC is one of them.

Their returns has been in the 20-25% CAGR or long *inaudible*. I was just comparing some of their metrics. For example, their revenue growth in the last five years has been 20%. To compare that to any of the US banks, JPMorgan Chase is 1.3%. Wells Fargo is .49%. US Bank is 1.27% in the last five years. *inaudible* is in the 17-20% range in the last 10 years, whereas JPMorgan Chase was 10%. Wells Fargo was like 12%. Net margins are in the 30% range, whereas JPMorgan Chase is like 22% and Wells Fargo is 24%. 

Asset turnover is also very good, the ratio is around 11-ish. However, they are not cheap. 

I wanted to submit this to you guys to comment on the valuation. So I’m not going to get into the valuation, but all I want to tell you is the story of this bank. There is a huge tailwind for them. The tailwind is that unlike the US, a huge section of Indian population until the 2000s was not in the mainstream banking. Close to 100 plus million people, just in the last one year, came on to banking. That trend is continuing. A lot are getting bank accounts. More people will be banking. 

HDFC is number two now. From nowhere from 1994, it is now number two with more than $300 billion in total assets. Also the other aspect is HDFC, one of the things about HDFC is they are known as the early adopters or fast movers in terms of technology. They were the first ones to bring mobile banking. 

They were the first one to implement centralized retail systems. That means what we take for granted in the US where you go to any branch, you can see your account, you can see your activity. That was not possible in India. 

Whatever I’m saying now is all well known. I’m assuming a lot of it is baked into the price already, but I’m not sure whether we are paying a higher price for it. However, I feel like taking a look at the Indian banking sector. I look forward to your comments.

Tobias Carlisle  15:08  

I’m having a little bit of trouble getting a valuation on HDFC. So I’m not really going to talk about the valuation but just in sort of broader terms, I’m a massive believer in India being one of the bigger growing economies in the world for the rest of my life. 

I think that if you look at where India is now relative to where it’s going to be, I think that it’s got massive growth in front of it. I don’t think that’s rocket science to figure that out. I also think that the banking sector in India is undersized for such a large economy. I do think there’s going to be even faster growth in the banking sector. I do think that almost everybody else in the world has figured that out.  

I think that if you look at India, HDFC is the biggest and the best. I think that it’s the one that’s in the indices, and I think it’s the one that a lot of people already own.

Therefore, I can see why it’s the sort of thing that Buffett would be attracted to if he could get the valuation right. Do you favor HDFC over something like ICICI or Axis? It’s sort of a little bit further down, and maybe not quite as not quite as picked over. Not quite as well known. Maybe you don’t need to do that because the underlying thesis is just so strong for India and for banking in India. 

What you really want to do is be in the biggest and the best. I think that’s a pretty good argument. Then the other side of it is the valuation is tough to sort of get my head around as a deep value guy.

Preston Pysh  16:28  

Just to piggyback on some of the stuff that Toby was saying, when you look at the top line on the company, it’s exploding to the upside. The other thing that you’re also seeing at the same time, as you’re seeing the price to book, also that multiple is growing significantly. So you just go back four years ago, you were at a price to book that was around a 10 and now it’s double that. It seems like everybody’s kind of jumping on the bandwagon. 

Then my concern really kind of becomes, am I the sucker that’s buying at a huge multiple and is this revenue sustainable at the growth rates they’ve got right now. I don’t know that right now where I sit, but those would be the things that I’d be digging into to try to understand a whole lot better of whether that multiple was something that’s going to be sustained or if it’s just something that’s being reflected because of the huge revenue growth that they’ve seen lately. 

I’d also be interested in looking at what kind of price the book the rest of the financial industry has in India. Is it also at around 20 for the other companies and the other banks?

Hari Ramachandra  17:26  

Yeah, these are all very good questions. I think I’ll take one by one. Most Indian companies are highly valued like 20 PE ratios in India is common. I will put the good ones are the ones that are discovered ,the ones that are in the indices, the blue chip kind of companies. 

However, I think to Toby’s point, I think Toby had a very interesting point. There are companies that are not as well known as HDFC or ICICI. HDFC, especially because it is trading on New York Stock Exchange so people anywhere can get access to investing in that. However,  there are other banks that are not as well discovered as HDFC, but are well run and are on a growth trajectory. 

There is one bank called Kotak Mahindra Bank. It is really well run, however, they don’t trade outside India, so that’s the disadvantage. The rumor is that Buffett might be interested in investing in that back.

Stig Brodersen  18:21  

Very interesting pick. I think I would look more into how the bank is going to profit from the rising middle class. The reason why I say that is, I know, this was not the context you were saying this, Hari, when you said 100 million people being unbanked. Good point. 

Facebook could say the same thing about people who are not online. People who are not online, they’re typically not where you get the most ad revenue. People who are unbanked in India now are not the people who are going to make money most likely for the next few decades. 

If you look at the rising middle class, how are they making money? Are they making money from the housing market, that’s a classical thing that they might do? What is the situation?

To get a better understanding of the debt they’re sitting with, how’s that financed? How does that work in India? I’ve no clue how that’s going to work. How much is that flowing back to the banks?

So from this 7-10% rise in GDP we might see for some time, we would say at least historically, if you’re looking at developing countries, a lot of that will flow back to the banks. It would be the same case here for a bank like HDFC. 

Then another thing I would like to put into the mix here, the political risk. You mentioned before that you have the banks that are nationalized. I know that this bank is classified as too big to fail. That’s not really what I’m talking about. What is happening if it’s been nationalized again? Is that a real threat? How will you be bought out if ever by the government?

I’m sorry, I’m going to put another question into that, Hari. How is a company or bank like this competing with government banks? What’s the dynamic between those two? I guess that’s another concern that I have.

Hari Ramachandra  19:53  

Your comment on the rising middle class and also of the bottom population who are just coming on to banking was really valid because I think banks will profit from the middle class. 

The Indian demographics is really positive for banks in the sense that if you look at most of the developed countries, especially in Europe, you will see that the demographic pyramid is top heavy. That means a lot of old people, few middle aged people. So that means they’re all in the savings mode or retirement mode. India isn’t that perfect demography where it’s a perfect pyramid. 

I can see the change when I was growing up in India back in the 80s and 90s. Hardly people own cars. Now everybody wants to have two cars, at least. Taking loans to buy cars is a norm. I mean, nobody even blinks an eye on that. In fact, there’s a lot of financing going on for everything, not just cars, but homes. 

One of the priorities for the government is to provide housing for everyone. A lot of initiatives and incentives by the government also to help ease the lending for the housing sector as well. 

You also asked me how does it compare with the public sector banks? The way I see is it’s a very unfair competition for public sector brands. 

The reason being public sector banks are saddled by government initiatives, the government comes up with policies to have a say to provide loans to certain sections of the population who are known to be not credit worthy. 

Because of the government policies, the public sector banks are mandated to lend money to them. Private sector banks go after the lucrative customers. The public sector banks are like the post office here. They have to serve everyone. They’re not really for profit. I mean, they’re supposed to be. 

The second one, you asked about political risk. What if India nationalized their banks again? That is a hard one actually. I don’t know. It has happened in the past. The way things are going now at least in the near term. 

I don’t see it happening again because there is a huge political risk for any political party to rewind the liberalization and capitalism. It has just taken roots in the past 20 years so much that the aspirations and expectations of the general public is much different than what it was like 20 to 30 years back.

Preston Pysh  22:22  

Alright, so we’re going to go ahead and have Stig throw out his pick.

Stig Brodersen  22:25  

Alright, guys, so my pick is Fonar. The stock ticker is FONR. I was really worried that you guys would come hard so I chose one of the smallest companies I could ever find and hope you didn’t have too many questions. 

I chose a company with a market cap of around $140 million. So this is probably one of the smallest companies, if not the smallest company, that we ever discussed on the Mastermind group. 

I have the same problem as Toby and I guess everyone else here is that if you’re looking at companies with a decent return, you have to look at something that has a bit of hair on it or at least something that is really untraditional. I’ve looked away from DOW and S&P 500. I found this tiny, tiny company.

So Fonar’s business is they design, manufacture, sell and service MRI scanners, which is used for diagnosing different human diseases. The founder was also the guy who invented the MRI scanner back in 1972. Even so, it’s not necessarily because they have been the most successful.

It is still trading at a very interesting multiple. It’s trading around 7, which is very similar to HP. It has been profitable since 2011. You have seen a steady uptick in revenue that has primarily come from the new business strategy of setting up their own centers where they are doing the diagnosis and taking pictures too. 

I could say generally about the business. It is a huge investment to set up for healthcare providers. Costs typically range between $1-3 million, sometimes even higher. Another huge expense is the suite in itself that can be in excess of $5 million. 

In general, it’s a growing market. The current market size for scanners is around $6 billion. Fonar has only $82 million. They’re definitely not a market leader in any way. They do not have a wide moat around what they do. They’re also depending on the general spending on health care. 

Whenever I’m looking at how to value the company, I’m looking at different scenarios either to include the historical growth of MRI scanners. I’ve also been looking into what is the general increase in healthcare and I also have a negative scenario. What if there is no increase at all? 

Having all this in mind, I look at around a 15% return for this company. 

I’m very interested to hear what you think about this tiny company. Is it just me being creative with the numbers whenever I think I can have a decent double digit return or what do you guys see?

Tobias Carlisle  24:57  

I love the pick. It’s currently in my Acquirer’s small cap screen. Everything about it on the numbers just is eye poppingly the good, great growth, massive return on invested capital. It’s cheap because as it trades under Acquirer’s Multiple, less than six, throwing off lots of free cash flow. Everything about it is very, very impressive. I find it really hard to find anything wrong with it.

Honestly, the DCF off the charts, I think it’s trading at like half price even assuming pretty kind of modest growth assumptions. I think it’s one of those stocks that really the only thing wrong with it is that it’s small, but if you can get over that, then I can see this being worth a lot more. I mean, it’s had a monster run since 2011. It’s up 15 times or something like that. So if it does that again, then this would be a great investment.

Stig Brodersen  25:47  

It’s interesting you would say that, Toby. When I looked at the numbers, it looked like a very interesting company. The issue is just like I’m not an expert in banking in India, I’m definitely no expert in MRI scanners either.

When I go through, like the reports, I do think they have a moat because their technology allows you to watch TV and you can sit. It’s much more comfortable for you as a patient to use that. I don’t know too much about that. It’s not too transparent for me at all. 

The R&D expenses for this company and for the industry is not that high. A lot of it really comes down to the sales team, as far as I can see through the numbers here. 

What I do like about the company is that they have a lot of cash. Again, this is a very small company with around 20 million in cash, which is a lot for a company like this. It has a strong balance sheet. 

If a company is very transparent for me, I would like to see a very nice dividend so I kind of feel that there is cash. I can see the cash come back to me as a shareholder. That’s not what I see with this company. They’re using all the cash they have to build new facilities and to acquire new centers. Currently, they have 26 in Florida and in New York. It seems to be perhaps the right strategy. 

I guess, for me, for a company like this, perhaps because I feel it’s too good to be true, I like to see some of that cash returned, especially if I don’t know more about it.

Preston Pysh  27:09  

I can tell you, Stig, from a fundamental standpoint, reviewing all the numbers, and then running an intrinsic value calculation or an IRR on the company. I’m coming up with anywhere between 10& to 12%, based on the numbers, so I think it looks fantastic from that standpoint.

The top line revenue is growing not aggressively, but it’s going up and the free cash flow is good. It’s a small company and therefore the price on it is very volatile. The volatility on this if you’re looking at it over like an annual timeframe is as close to 30%. If a person is going to buy this, they just kind of need to be prepared to be whipsawed all over the place. 

The only negative thing I can say about this is if you start off and this is how I look at my investing approaches, I always start off with the fundamentals and try to understand whether I think that there’s a lot of value to be had. 

In this case I would say that there is, but then when I transition over to the momentum side of it and try to understand how is the market treating this company right now? Is the price action suggesting that it’s in a positive trend? It’s not. The market is not treating this as having a positive trend. 

How I’m looking at that just so people understand what I mean by that is, if the price action is positively sloped, and it’s staying inside of that 30% volatility range, then I would call that a green and all things are a go. If the fundamentals are good, and the momentum is good, then I see that as a buy.

However, right now, it’s not really kind of meeting my momentum metric and I think that it has cause for concern. So for me, I’m just going to sit back. I’m going to continue to watch this because I think there’s a lot of value here but I’m not going to enter into the position. I’m just going to continue to watch it until I’d probably see a change in that momentum trend.

Stig Brodersen  28:54  

Well, thanks for the comment, Preston. I’m really happy you always bring this piece about momentum. As value investors, it is really hard not to look at this general Warren Buffett kind of rule if the valuation is right, just go ahead and buy it, because you don’t know what’s going on. But perhaps you are right. 

Talking about that piece, you do see a bit of insider selling. It’s not a lot. It’s from the founder. So I’m not too concerned about that. I just wanted to mention that. Also, that perhaps something one should take a look at. 

If you do see a negative trend for a very, very small company, it doesn’t have a lot of volume. I think the average is around 10,000 shares or something like that for a $20 company. Hari, any comments on your end

Hari Ramachandra  29:36  

I was looking at its competitors and it is GE Healthcare and Siemens. All those guys. 

Two thoughts came to my mind. One, they can outcompete Fonar with their marketing budgets, or it can be an acquisition target too. So you might benefit from the acquisition spree among the bigger companies as well.

Stig Brodersen  29:54  

It’s a really good point. If you do look at the competitors, they are generally much bigger. It is, however, hard to get a really firm grasp of the MRI market, at least for me, because of the way that if you look at a company like GE, a huge competitor. You have a company like Canon. 

Huge companies and it’s not always as transparent what they’re doing in that specific industry, which again leads me back to this idea of with the kind of return that they’re achieving right now, I would love to collect my 6-8% back in dividends or whatnot. 

If I could do that, I think it would take a lot of risk off on my end, I still feel that evaluation is very generous. It is just as a market follower in many ways in such a small company, and it has almost no coverage. It’s just really hard for me to get a really firm grasp of where we are with that company, which is perhaps also why it’s only trading at seven times PE. 

Alright guys, thanks for the comments and the thoughts you have to Fonar. Just one thing I’d like to put out there, Preston and I write up different thoughts on various picks that we find interesting. Only a few weeks ago, we did a write up of Fonar. It’s on our free intrinsic value index. 

Everyone can just go and check that out on TIP Academy, or they can simply sign up at tipemail.com. They automatically get signed up and have analysis like the one I’m providing here sent to their inbox.

Preston Pysh  31:19  

All right, so I’m going to talk about my pick. Just a little disclaimer here. I tweeted about this idea of this position, let me tell you, I have received a lot of hate mail over this idea. 

I think it’s going to be fun to kind of go through. My recommendation this week is ticker SH. That is SH and this is the S&P 500 short. I guess if you think the S&P 500 is going to go up, then you’d want to own something like an SUI, or you think the S&P 500 is going to go down, you probably want to own something like SH.

Here’s my narrative. I’m not one to really short. I don’t have a lot of experience shorting. I think people need to take some of my comments with a grain of salt here. I think if you’re trying to put on a position like this, and you don’t have a lot of experience in the markets, and even if you do have a lot of experience in the markets, it might not be the best decision. I want to emphasize that before we even start talking about it.

I purchased this, my average purchase price was around $28.30 cents when I put this position on. Currently, the price is at about $30.45 cents. So I’m already up in this position about $2 from the time I put this on.

I’m looking to increase that position, if the price of anything below $28.90 cents is where I’m looking to add to the position and that point is really the 200-day moving average on this ticker. If it goes below that 200 day moving average, I’m looking to add to the position. 

Now with that said, I’ve also set up a stop limit for myself on this. So that if I am, in fact wrong, and I’ve already decided what point I would consider myself wrong, and the stop limit for me is the $27.40 cent mark, I would consider myself wrong in this position. I would liquidate and I would take a loss on the idea. I just want to put that out there upfront so people kind of understand how I see it. 

This is my narrative. All major central banks around the globe are currently tightening, they are not loosening monetary policy like they have over the last 10 years. The global stock market is well below the 200-day moving average, and the moving average has a negative slope. 

I think that second part is really important because a lot of the times when whenever you’ll see the price go below the 200-day moving average on something like the global stock index, you’ll see it quickly rebound and actually bounce right off that 200-day moving average. Whenever you see that quick bounce off the 200-day moving average, it’s typically whenever the 200 day moving average still has a positive slope. Right now. we don’t see that.

We see the price really kind of, especially on the global side, you’re seeing the price sustain below the 200-day moving average by quite a bit, and the slope of the line is actually starting to go negative. 

The other point that I want to highlight is that the unemployment numbers are at all time lows. They appear to be starting to flatline, their sub 4%, which hasn’t really happened for decades. The bond yield curve is extremely flat. Some portions of the curve, they’ve actually started to invert. We’re expecting the federal funds rate to go up to around 2.5%. here by the end of December.

If the Fed decides to hold steady on the tightening, which many are suggesting, might have started happening after this quarter, maybe one more quarter of raising the federal funds rate. If they do start to hold steady, I think that you’re going to see the dollar really kind of have a strong sell off. I think that that’s going to have a significant impact on rates. You’re going to start to see a lot of that being priced into the bond yield curve which then is going to have an impact into the equity market. 

One other point that I wanted to highlight was that we were seeing buybacks for the S&P 500. They’ve exceeded $620 billion for 2018, which you go back to 2007. That was around $590 billion back then. We’re above that buyback level. And there’s been no other time in the last basically 20 years where we’ve seen buybacks that high. So buybacks are typically an indicator of really good times and probably the peak of good times. 

We’ve seen the Shiller CAPE ratio peak out at about 33. Today, it’s back down to 28.7. My expectation is that that’s not going to go back up higher than where we’ve seen it. 

I’m laying out a very bare case here. The hard part of getting this right is really kind of buying it. First of all, if this call is right, let’s say that the market is going to go down, I think it’s really hard for people to put the position on at the right times because the time the buy is whenever the market price is going to be really kind of accelerating up. It’s going to be looking like you’re wrong, like any position, and that’s when you really need to be buying more of the shares, if in fact we are seeing a topping process and we’re going to see a year two or three of the market going down. 

I think that that’s the real challenge for people that would be putting this on. It’s going to feel really comfortable to buy this on days where you have a 3% drop in the market, but that’s probably the days you need to be maybe offloading some of the position so that when the days when it’s going back up, that’s when you need to be buying.  That’s going to be really, really hard from a psychological standpoint. 

So that’s my pitch. I don’t have a lot of conviction in this position. I would say that, if I had to stick a probability on it, I’d say that 55% sure that this might be right. I don’t know, but it’s not a lot. 

I think that that’s important for people to understand too, because as I’m dipping… I would call this dipping my toe in the water to kind of see whether this is a good idea or a very bad idea. If it goes past that stop limit that I had set previously, which for me is around $27.40 cents. If it goes past that, I’m going to sell the position and just kind of reassess, and maybe just stay away from something like this. 

However, if people do want to kind of track my thought process on this and how I continue to play it, I’ll be talking about it more on Twitter. If I’m wrong, everyone can kind of sit around and get a good laugh at my expense. Literally at my expense.

Tobias Carlisle  37:23  

I think it’s a really good idea. I’ll just tell you why. I’ve done this similar analysis. You can look at the market in very simple terms as being trend and value. If you look at it in terms of trend, the 200-day moving average or the 10-month moving average, same thing. 

If the 200 day is up, the market is up. If the market closes below the 200-day, the market is down. That’s how complicated that analysis is. Then you can look at the Shiller PE when it’s above and below average. So that gives you four states that the market is trending up and overvalued, trending up and undervalued, trending down and undervalued, trending down and overvalued. 

In those four states, it’s no surprise to anybody, I’m sure that if the market is trending up and undervalued, that’s where you get the best returns. The market, since 1950, has managed to 15.5% each year on average under those conditions.

When the market is trending down and expensive, which is the current state that we are in the market has averaged negative 1.3% per year under those conditions. Then the other two are sort of mixed, trending up and expensive is actually 8.4%. Trending down and cheapest 6%. There is time to be nervous in the market, and that is when it’s below the 200-day. It’s extremely expensive, which is where we find ourselves now.

The main reason to be nervous though is that this is where all the big crashes occur. So all the biggest crashes occur when the market is in this kind of state. The thing to be sort of nervous about when you put in a position like the sun, I don’t mind the instrument that Preston is using to invest in this because it’s you’re putting a long position into SH. So it can go against you, but you can’t lose more than you put into this position. That’s one thing to think about. 

However, the reason that these sort of positions work and the reason that that analysis that I just gave before works is that the stock market has this behavior where when it sells off, it sells off very deeply, but most of the time, it doesn’t work. 

What that means is that when you put this position, this state has existed at various times over the last 10 years. If you put this position on, you would have lost money in it. It’s likely that you put money on in this position and you lose money because the frequency of these positions being right is low. 

However, when they do work, the magnitude of the win is so big that it pays for all of the other times that you’ve put it on. That’s a reason why you want to put it on but then you need to be watching the 200-day and ready to pull it off again when you are proven wrong. 

That’s sort of my very brief analysis of this scenario. I would say if you’re going to put a position like this on, you put it on, and then you go and find the thing that you wanted to buy along. Then you wait for it to get cheap and you buy that thing long. Then you might put a little bit more of the position short on and you can go and find another long that you like to buy so you use it to sort of… The way I use it is to protect my long positions rather than sort of an outright speculation.

Stig Brodersen  40:24  

My first comment to this is that Preston is probably the most courageous member of this group. Think about shorting the market and then tell everyone on Twitter, of all places in the world. I kind of like that. 

It’s a tricky thing. We talked about showing multiple times here on the show. We always talk about how difficult it is to get the timing right. We’ve also talked about the market being overvalued for quite some time. Yes, it is overvalued now. It wasn’t a year ago and two years ago. So when is it going to *inaudible*?  

I think it is interesting also what Toby mentioned that Preston is probably wrong, but his upside if he’s right is so much higher. So that’s always the calculation we need to make. 

I’m curious, Preston, with a pick like this, which is very expensive. It has an expense ratio of .89%, which is actually not a big issue because you’re typically only holding this for a very, very short period of time. What are your thoughts on an exit point, assuming that you’re right, assuming that the market does crash, when has it crashed enough for you to exit the position?

Preston Pysh  41:27  

I’m really looking at it for the volatility of the S&P 500. The S&P 500 for me, the volatility is around 10%. As long as the price action kind of stays within that 10% range on the way down, if it is in fact going down, I’ll just continue to hold it. I’m not going to try to really kind of time anything. I’m just going to really look at whenever it sets its newest low, if the price of whatever that low would be, are really on… This would be high if we’re talking specifically for SH. I know this will get convoluted if we start talking whether it’s going up or down, so let’s just talk about SH. 

As SH would potentially be going up, if I’m right, the price action should operate within a 10% volatility. So let’s say that it goes up to $40 and that’s the highest price that it goes to. If the price drops back down below $36, that would be my exit point at that point, because that’d be 10% below the highest point that it basically achieved. 

However, as long as it stays within that 10% volatility range, I’m just going to continue to hold it. So if it goes up to $90, and comes down to $81, then that would be the point I would sell it.

Tobias Carlisle  42:34  

I wrote an article discussing these metrics that was in Forbes on January 14, 2016. So I’ll make sure that I send a link through you guys so you can stick it in the show notes. This one has those statistics I was just discussing then, but it is worthwhile mentioning that these conditions did exist in January 2016, and it didn’t then follow through. This is just one of those things that you need to understand frequency and magnitude. Frequency bit here is likely wrong but when it works, you make a lot of money.

Preston Pysh  43:05  

I think that that’s a really good point, Toby. I’ve thought through that as well. The things that I’m seeing that are different between now and back in the 2015 to 2016 timeframe, whenwe saw a lot of these similar conditions was that the central banks were acting very differently back then than they are now.

Back then, a lot of I know over in the ECB, they were still aggressively loosening. You had Japan still aggressively loosening and now you don’t necessarily have that happening. 

Also, back then you didn’t have the bond yield curve nearly as flat as what you have right now. Then the last thing that I would tell you is that the US already did this massive tax play that shot the market up at huge rates in the last two years. They basically don’t have that play here at this point in time to do over again. I think that that’s very different. I think that when you look at the amount of unemployment that was different now and way lower than where we were at in the 2015 to 2016 timeframe. 

So I guess for me, that’s my justification. That doesn’t necessarily mean that it makes it right. but I think that it adds maybe a little bit more probability to the fact that the call could potentially be right compared to back in the 2015 to 2016 timeframe.

Tobias Carlisle  44:23  

I’m not arguing that you’re wrong, either. I’m just saying that when you’re putting these positions on, you have to approach them probabilistically. You have to realize that each time you put it on is likely not right. But the one time that you do put it on and you get it right, you’re going to be very right. 

Preston Pysh  44:38  

Then your ego explodes. 

Tobias Carlisle  44:41  

Well, then you are famous. Then you’re one of the guys in The Big Short, or you’re the greatest trade ever, or something like that. However, you got to realize that for all those guys that were in The Big Short, there are other guys who came beforehand. There were a lot of arrows in the back before somebody got it right. 

Preston Pysh  44:58  

Now, I think what you’re saying is absolutely valid. I think that’s why I’m saying my confidence level is very, very low in this. I think this is right, I’m putting a little bit of money on the position to feel what that is like. So far, it’s been great because I kind of put it on at a good position. I’m a little bit ahead. I think that helps me feel a little bit more comfortable talking about it, to be quite honest with you, but we’ll see how things continue to progress. 

I think it’s really important that people understand that I have put a stop on the position that if the price goes below the $27.40 cents. I’ll liquidate out of it and then reassess and rethink about things.

Hari Ramachandra  45:37  

Would you say this as an insurance policy in general, got to have it all the time so kind of have a hedge against your long positions?

Preston Pysh  45:48  

I don’t personally. I don’t do it that way.

Tobias Carlisle  45:51  

No, this is you put it only below the 200-day, that’s that particular trade. There are other trades that you could put on the tail risk type trades that you can keep on all the time. However, tail risk hedging has been extremely expensive for the last sort of five or seven years. There are a lot of people who have lost a lot of money. A lot of the money went to that ETF XIV that eventually blew up. 

That was exactly what Talib was talking about. Talib would have been on the other side of that XIV trade. I’m not saying that he did, but he’s looking out for those strategies that make a little bit of money all the time. But given enough volatility in the marketing and vomit the whole lot back and more. Tail risk has been a very tough place to be in for a long time. 

However, there are going to be some famous tail risk investors who are going to get it right when the market does eventually book. *inaudible* Capital is one of them. Not a well known name, but will be a well known name sort of post the next *inaudible*. 

Preston Pysh  46:44  

Well, we’ll see what happens. I think it’s fun to talk about and I think it’s fun to document it. There’s a very strong possibility that this could be a bad position, but you know what? It’s going to be a great learning example for everybody to observe it, if it is in fact wrong. So I think it’ll be kind of a fun thing to kind of track and do.

Stig Brodersen  47:06  

Well, I mean, the interesting thing is you are probably right, Preston, or you are right. The question is if you’re going to be wrong before you are right.

Preston Pysh  47:15  

All right, Toby, go first tell people who you are. Tell everyone about some of the different things that you do out there.

Tobias Carlisle  47:21  

I’m an investor and an author. I run a website called acquirersmultiple.com, which has stock picks if you’re interested in the strategy on the site. There’s lots of blog posts and things like that. There’s also a book available through Amazon called “The Acquirer’s Multiple” which is a condensation summary and simplification of three other books that I have written “Quantitative Value,” “Deep Value,” and “Concentrated Investing.” 

The strategy is a deep value strategy looking for sort of private equity and activist type stock picks, so I like deeply undervalued positions, where the business is a little bit busted, but there’s a possibility that if you get some activist or private equity attention, or management just starts doing the right thing, buy back stock, whatever, it’ll do better. It’s been a really rough period of time. It’s only been not working for about 10 years but I’m hoping it’ll start working sometimes.

Hari Ramachandra  48:11  

I guess I’m the odd man out here and a geek from Silicon Valley hanging out with all these financial wizards. I learned a lot from you guys and others, and whatever I learned I just write in my blog, the butsbusiness.com. Happy to be in touch with you guys there on Twitter. My handle is @HariRama.

Preston Pysh  48:36  

We’ll have Toby and Hari’s Twitter handle in the show notes. We’ll also have links to their websites that they discuss there. So if you guys want to check that out, we highly encourage you to click on those links and check their information out.

Stig Brodersen  48:49  

All right, guys. That was all that Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week. 

Outro 48:59  

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